TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING THE IMPACT OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 BEFORE THE SUBCOMMITTEE ON SECURITIES COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE July 24, 1997 Chairman Gramm, Senator Dodd and Members of the Subcommittee: I appreciate the opportunity to present testimony on behalf of the Securities and Exchange Commission ( Commission ) concerning the impact of the Private Securities Litigation Reform Act of 1995 ( Reform Act or Act ).<(1)> I. INTRODUCTION Congress enacted the Reform Act just over a year-and-a-half ago. Our experience under the Act is based on activity during an even briefer period of time, because there was a period of about three months after the Act was passed before plaintiffs began filing new actions in earnest. Based on this early and limited data, the Commission staff, under the direction of General Counsel Richard H. Walker, prepared a Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995 ( Staff Report ), which we submitted this April. We are submitting copies of the Staff Report to the Subcommittee in <(1)> Pub. L. No. 104-67, 109 Stat. 737 (1995). connection with our testimony and respectfully request that it be included in the record. There have also been a number of private studies analyzing the impact of the Reform Act.<(2)> The relatively scant statistics to date have received considerable attention as many observers attempt to predict whether the Reform Act will succeed in achieving its stated goal of curbing frivolous securities class action litigation. Despite limited experience under the Reform Act, there already have been a number of proposals introduced -- at both the state and federal levels -- that would shift the balance that Congress struck when it enacted the Act. Most prominent of these was Proposition 211, a ballot initiative put to California voters last November that would have created broad private rights of action based on claims of fraud, many in conflict with provisions of the Reform Act. The measure was widely opposed by, among others, President Clinton, members of Congress, and myself, and, following an expensive and contentious public debate, it was defeated by a 3 to 1 margin. Concerns have been raised that measures similar to Proposition 211 may be introduced in other states. In fact, the trend has been to enact reforms that limit, not expand, private rights of action. Three states -- Arizona, Montana, and Ohio -- have adopted the reforms found in the Act, and similar legislation has been introduced in California. Even before Proposition 211 was defeated, counter-proposals began to surface that would nullify the measure if it were adopted and ensure that <(2)> See Joseph A. Grundfest & Michael A. Perino, Securities Litigation Reform -- The First Year s Experience, CORNERSTONE RESEARCH, Feb. 27, 1997; Denise M. Martin et al., Recent Trends IV: What Explains Filings and Settlements in Shareholder Class Actions?, NATIONAL ECONOMIC RESEARCH ASSOCIATES (1996) ( NERA Study ). ======END OF PAGE 2====== similar measures would not be introduced in other states. The counter- proposals to Proposition 211 urged, for the most part, some form of federal preemption of private state securities fraud suits. Two such proposals are now pending in the House of Representatives.<(3)> At the President s request, the Commission has been monitoring closely developments under the Reform Act and the Act s impact on the effectiveness of the securities laws and on investor protection. Among other activities, we have closely followed all federal litigation under the Act, intervening as amicus curiae where important issues have been raised; we have monitored litigation in state courts that may affect the Reform Act s effectiveness; we have reviewed and are continuing to evaluate legislative proposals that would enact further reforms; and we have reached out continuously and widely to those who are affected by the Reform Act -- issuers and their advisers, individual and institutional investors, plaintiffs and defendants counsel, as well as others. These efforts continue. With just a year-and-a-half s experience under our belts, there is much that we have learned about the Reform Act, but much more that must await developments in the courts -- both state and federal -- and in state legislatures. We applaud this Subcommittee for conducting this hearing to assess the early effectiveness of the Reform Act. Two of the key questions raised at today s hearing are whether the Act is achieving its aims and, if not, whether further reform is required. A little over two years ago, I testified before this Subcommittee regarding litigation reform legislative proposals. I stress today, as I did then, the importance the Commission <(3)> H.R. 1689 (introduced by Representatives White (R-WA) and Eshoo (D-CA)); H.R. 1653 (introduced by Representatives Campbell (R-CA), Klug (R-WI) and Dooley (D-CA)). ======END OF PAGE 3====== places on private antifraud actions. The Commission has long maintained that private actions provide valuable and necessary additional deterrence against securities fraud, thereby supplementing the Commission's own enforcement activities. Moreover, private suits are the primary method for compensating defrauded investors. Investors are not well served, however, by frivolous lawsuits, which raise the cost of capital and in no way deter fraud. The Reform Act was passed in an effort to discourage such lawsuits. We support that goal. ***** II. THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 The Reform Act revised both the substantive standards and procedural rules governing private actions under the federal securities laws. The Act primarily affected class actions, the type of securities suits most prone to abuse due to the potential for expensive and time-consuming discovery, enormous damages and the plaintiffs lawyers de facto control over litigation decisions. Among the Act's principal provisions are: (i) a "safe harbor" for forward-looking statements; (ii) a stay of discovery while a motion to dismiss is being decided; (iii) heightened pleading standards requiring specific recital of facts supporting a charge of fraud; (iv) a "lead plaintiff" provision designed to wrest control of class action litigation from lawyers and to empower investors with larger stakes in the company subject to the lawsuit; and (v) a system of proportionate, as opposed to joint and several, liability for defendants who are not found to have knowingly committed fraud. ======END OF PAGE 4====== Shortly after the Reform Act became law, President Clinton wrote to me requesting that the Commission advise him and the Congress about the impact of the Act on the effectiveness of the securities laws and on investor protection, and on the extent and nature of any litigation under the Act. On April 15th of this year, I submitted the Staff Report to the President and Congress. The Staff Report s key findings shape my testimony today. ***** III. REPORT TO THE PRESIDENT AND THE CONGRESS In preparing the Staff Report, the Commission's Office of the General Counsel reviewed the complaints from federal securities class action lawsuits filed in 1996, analyzed the court decisions under the Act, and discussed the effects of the Reform Act with a variety of interested parties. In addition, the staff reviewed a sample of complaints filed in securities class actions brought in state courts during 1996. The Report made the following observations: * The number of companies sued in securities class actions in federal court declined in the first year following passage of the Reform Act. * The number of state filings increased for that same period, according to reports by outside parties that were reviewed by the staff. Moreover, many of the state cases were filed parallel to a federal court case in an apparent attempt to gain discovery in the state case for use in the federal case where the Reform Act s discovery stay would apply. * Most federal securities class action complaints filed in 1996 appeared to contain detailed factual allegations specific to the action. ======END OF PAGE 5====== * Based on the staff s review of a small sample of cases, the allegations contained in state court complaints were generally similar to those in the federal complaints, but state complaints having no parallel federal action were more likely to be based solely on failed forecasts. * Secondary defendants, such as accountants and lawyers, were being named much less frequently in federal securities class actions.<(4)> It is unclear, however, whether this decline can be attributed primarily to the Reform Act or to the Supreme Court's 1994 decision in the Central Bank of Denver case, which eliminated private liability for aiding and abetting in actions under Section 10(b) of the Securities Exchange Act of 1934 ( Exchange Act ).<(5)> ù Institutional investors were not yet actively seeking to become involved in securities class actions, which continue to be controlled by plaintiffs' law firms. <(4)> The staff s review of complaints in the 105 class actions filed in 1996 revealed that accounting firms have been named in six cases, corporate counsel in no cases, and underwriters in 19 cases. By contrast, a report of the Big Six accounting firms concluded that the number of audit-related suits filed in both state and federal court against these firms for the years 1990 to 1992, was 192, 172, and 141 respectively, Letter from Mark H. Gitenstein & Andrew J. Pincus, Mayer Brown & Platt, to Walter P. Schuetze, Chief Accountant, Securities and Exchange Commission, at 14, Table VIII, (June 11, 1993), although these numbers were not limited to securities class actions. Moreover, this report concluded that during these same years the number of cases either settled or dismissed against the Big Six firms which involved claims under Section 10(b) was 18, 35, and 58 respectively. Id. at 16, Table IX. The NERA Study reported that during the period 1991 through June 1996, accountants were defendants in 52 reported settlements (as opposed to complaints), underwriters were defendants in 80, and law firms were defendants in 7. <(5)> Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). ======END OF PAGE 6====== * The race to the courthouse to file a complaint slowed somewhat. Although a few cases were filed within days of the release of negative news by the issuer, most were filed after at least several weeks had passed.<(6)> * The courts have strictly applied the discovery stay imposed by the Reform Act during the pendency of a motion to dismiss. Coupled with the heightened pleading standards, the stay has made it more difficult for plaintiffs to prosecute securities class action lawsuits. * Despite the new safe harbor, the staff received reports that companies appear to be reluctant to provide significantly more forward-looking disclosure beyond what they provided prior to enactment of the Act. Although the Staff Report made these preliminary observations, its main conclusion was that it was too soon to make a definitive assessment of the Act's impact, and therefore, the staff did not recommend any legislative changes at that time.<(7)> The year-and-a-half since passage of the Act has not allowed for sufficient practical experience with its key provisions or for many court decisions interpreting those provisions. In particular, the appellate courts have had virtually no opportunity to interpret the Act. No case has made its way to a jury, relatively few motions to dismiss have been decided, and there have been <(6)> The average time between the end of the class period and the filing of the first complaint was 79 days as compared with an average lag of 49 days for 1991 to 1995. <(7)> Commissioner Wallman submitted a separate statement indicating that he did not support the Staff Report's conclusion that no further legislative changes were recommended at that time and that he disagreed with the staff s methodology. Commissioner Hunt also submitted a separate statement endorsing the Staff Report's conclusion that the available evidence did not call for legislative changes. Copies of the Staff Report and the statements have been provided separately to the Subcommittee. ======END OF PAGE 7====== even fewer reported settlements. Important provisions such as the safe harbor s meaningful cautionary language requirement, the mandatory sanctions inquiry for frivolous filings and the proportionate liability provision have yet to be addressed at any stage of the litigation process. The Numbers of Federal Class Actions Filed The Staff Report identified 105 companies sued in federal securities class actions during the first year following passage of the Reform Act. By contrast, Securities Class Action Alert, a newsletter which tracks these actions, has reported that approximately 153 companies were sued during 1993, 221 during 1994, and 158 during 1995. Accordingly, there was a 34% drop-off from the number of companies sued in federal court in 1995, a 52% drop-off from the number of suits in 1994, and a 31% drop-off from the number of suits in 1993. So far in 1997, the numbers appear to have rebounded to their pre-Reform Act levels. The staff has identified 88 federal securities class actions filed so far this year. If this pace were to continue, this would project to 157 federal securities fraud class actions for 1997. As the Staff Report noted, however, meaningful conclusions cannot be drawn about the effectiveness of the Reform Act purely from the raw number of filings. Numbers alone do not reveal whether the cases are meritorious or meritless. For various reasons, primarily the novelty of the Act, 1996 may have been an aberrational year for class action filings. Better indicators of the effectiveness of the Act in weeding out frivolous actions -- and affording room for meritorious ones -- would be the nature of the allegations found in the complaints, decisions on motions to dismiss, and ======END OF PAGE 8====== terms of settlements reached. To date, however, few motions to dismiss have been decided, and only a handful of settlements have been reached. The Allegations The Staff Report analyzed each complaint filed under the Reform Act in 1996 to determine the types of claims being asserted. The staff s review revealed that only 12% were based solely on forecasts that did not prove accurate. The legislative history of the Reform Act indicates that such suits were a central concern of Congress. Most complaints contained fraud allegations that either went beyond a mere failed forecast, or that did not include such forecasts at all. Many were premised on allegations of either insider trading (48%) or accounting irregularities (43%).<(8)> A smaller percentage contained allegations of restatements of previously reported financial results (18%), government investigations (15%), or outright Ponzi schemes (2%). The Motions To Dismiss The staff has identified 28 rulings on motions to dismiss federal actions under the Reform Act to date. The results are as follows: six actions have been dismissed with leave to replead; six have been dismissed without leave to replead; three have been dismissed in part; and 13 have been denied. Thus, more than 50% of the motions to dismiss have been granted at least in part. <(8)> A recent study found that prior to the Reform Act, 20.7% of securities class actions contained allegations of insider trading and 33.9% contained allegations of misrepresentations in financial statements. Laura E. Simmons, The Importance of Merit- Based Factors in 10b-5 Litigation, CORNERSTONE RESEARCH, Table 2 (Nov. 14, 1996). ======END OF PAGE 9====== These motions have focussed mainly on the Act s strict pleading standards that require that the complaint "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." The courts are divided over the proper interpretation of this language, based primarily on their differing views of the legislative history. Eight courts have adopted the traditional Second Circuit standard for pleading scienter, one of the essential elements of all securities fraud suits.<(9)> This standard allows plaintiffs to plead facts giving rise to a strong inference that the defendants acted either knowingly or recklessly, or that the defendants had a motive and opportunity to commit the fraud. At least five other courts, however, have adopted a more stringent standard. Four of these hold that only conscious misrepresentations or omissions,<(10)> or in one case deliberate recklessness, <(11)> satisfy the Reform Act's pleading standard. The fifth case essentially eliminates the motive and opportunity prong as a <(9)> Marksman Partners, L.P. v. Chantal Pharmaceuticals Corp., 927 F. Supp. 1297 (C.D. Cal. 1996); Zeid v. Kimberley, 930 F. Supp. 431 (N.D. Cal. 1996); STI Classic Fund v. Bollinger Indus., Inc., No. 3:96-CV-823-R, 1996 WL 866699 (N.D. Tex. Nov. 12, 1996); Fischler v. AmSouth Bancorporation, No. 96-1567-CIV-T-17A, 1996 WL 686565 (M.D. Fla. Nov. 14, 1996); Rehm v. Eagle Fin. Corp., 954 F. Supp. 1246 (N.D. Ill. 1997); Fugman v. Aprogenex, Inc., 961 F. Supp. 1190 (N.D. Ill.1997); In re The Wellcare Management Group, Inc. Sec. Litig., 964 F. Supp. 632 (N.D.N.Y. 1997); Page v. Derrickson, No. 96-842-CIV-T-17C, 1997 WL 148558 (M.D. Fla. Mar. 25, 1997). <(10)> In re Silicon Graphics Inc. Sec. Litig., C 96-0393, 1997 WL 337580 (N.D. Cal. June 5, 1997); Friedberg v. Discreet Logic Inc., 959 F. Supp. 42 (D. Mass. 1997); Powers v. Eichen, Case No. Civil 96-1431-B (AJB) (S.D. Cal. Mar. 13, 1997); Norwood Venture Corp. v. Converse Inc., 959 F. Supp. 205 (S.D.N.Y. 1997). <(11)> In re Silicon Graphics Inc. Sec. Litig., C 96-0393, 1997 WL 337580 (N.D. Cal. June 5, 1997). ======END OF PAGE 10====== basis for pleading fraud.<(12)> While these decisions address the pleading requirements of the Reform Act, they may also affect the substantive liability requirements of the securities laws themselves. The law is well established in each of the ten federal appellate courts that have considered the issue, that proof of recklessness satisfies the scienter requirement and can establish liability under the antifraud provisions of Section 10(b) of the Exchange Act.<(13)> The Commission has consistently supported a recklessness standard of liability because such a standard is needed to protect investors and the securities markets from fraudulent conduct and to protect the integrity of the disclosure process. We are closely monitoring the decisions under the Reform Act which hold that allegations of recklessness do not satisfy the Act s pleading requirements, and we intervened in the Silicon Graphics case to urge the court to follow well established case law upholding recklessness as a basis for liability. Based on the limited data available, the Staff Report concluded that it is too early to make a definitive assessment of the Reform Act s effectiveness. Again, the raw number of cases filed cannot tell us whether <(12)> In re Baesa Sec. Litig., 96 Civ. 7435 (S.D.N.Y. July 9, 1997). <(13)> Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir. 1978); Rolf v. Blyth Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978); In re Phillips Petroleum Sec. Litig., 881 F.2d 1236, 1244 (3d Cir. 1989); Broad v. Rockwell Int'l Corp., 642 F.2d 929, 961-62 (5th Cir.), cert. denied, 454 U.S. 965 (1981); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023-24 (6th Cir. 1979); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044 (7th Cir.), cert. denied, 434 U.S. 875 (1977); Van Dyke v. Coburn Ent., Inc., 873 F.2d 1094, 1100 (8th Cir. 1989); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 (9th Cir. 1990), cert. denied, 499 U.S. 976 (1991); Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir. 1989). ======END OF PAGE 11====== those cases are meritorious or meritless. While the allegations found in the complaints appear to be substantive on their face, the merits of these cases can only be decided by judges and juries on the basis of the evidence. Finally, the district courts are divided on the proper pleading standard under the Reform Act. Until the appellate courts have an opportunity to resolve this conflict, it is premature to evaluate the effect of this most significant reform provision. Recently, the Staff Report's conclusion that it is too soon to assess the impact of the Act was reinforced. Two weeks ago, National Economic Research Associates ( NERA ) issued a study finding that the 1996 trends in the number of federal and state class action filings were "transient."<(14)> The study found that the federal numbers during the first five months of 1997 had returned to the level observed in the five years prior to passage of the Reform Act. Our staff has identified 88 new cases filed in federal court during 1997, which would project to 157 filings on an annualized basis. This is in line with the numbers from 1991 through 1995, as reported by NERA. Just as the trend in filings for 1996 proved to be short-lived, there is no guarantee that the 1997 numbers will reflect a lasting trend, and, as previously noted, the number of filings tells us little. In light of the variance that we have seen in the early numbers, and for the other reasons set forth here and in the Staff Report, the Commission believes the Staff Report's conclusion that it is premature to assess the Reform Act's impact still holds true today. <(14)> Federal Shareholder Class Action Filings Rise to Pre-Reform Act Levels As State Filings Fall, NERA (1997). ======END OF PAGE 12====== Areas Warranting Particular Attention The Staff Report, however, did identify three areas where the Reform Act is not yet achieving its intended goals. First, the lead plaintiff provision has not encouraged institutions to become class representatives. Second, the safe harbor has not induced companies to disclose more forward- looking information. Finally, the discovery stay has been circumvented by the filing of parallel state actions where discovery may be had. Lead Plaintiff Provision To date, the lead plaintiff provision has fallen short of expectations. This provision creates a presumption that the plaintiff or group of plaintiffs with the largest financial stake in the lawsuit during the class period should be appointed as class representative, with the authority to choose class counsel. Congress adopted this provision in an effort to put shareholders, rather than plaintiffs' attorneys, in charge of class actions. This provision has not yet produced the results that Congress intended. The Staff Report found that in only 8 of the 105 class actions filed during the Act's first year did institutions seek to be named lead plaintiff.<(15)> <(15)> Gluck v. Cellstar Corp., No. 3:96 Civ. 1353-R (N.D. Tex., complaint filed May 14, 1996) (State of Wisconsin Investment Board); Malin v. IVAX Corp., No. 96-1843-CIV-Moreno (S.D. Fla., complaint filed July 15, 1996) (Pennsylvania School Employees Retirement System Pension Fund); Mark v. Fleming Cos., No. CIV- 96-0506-M (W.D. Okla., complaint filed Apr. 4, 1996) (City of Philadelphia, acting through its Board of Pensions and Retirement); In re Summit Technology Sec. Litig., No. 96-11589- JLT (D. Mass., complaint filed Aug. 2, 1996) (Teachers' Retirement System of Louisiana); Teachers' Retirement System of Louisiana v. Micro Warehouse, Inc., 396CV02166 (D. Conn., complaint filed Oct. 25, 1996) (Teachers' Retirement System of Louisiana & Pennsylvania School Employees Retirement System Pension Fund); In re Cephalon, Inc. Sec. Litig., Civ. Act. No. 96 CV-0633 (E.D. Pa., complaint filed Jan. 29, 1996) (Sands Point (continued...) ======END OF PAGE 13====== Why is this provision not working? In preparing the Staff Report, the staff met with representatives of both public and private institutional investors, and we continue to solicit their views. Their primary concern is litigation-related expense. Making key personnel available for lengthy testimony and opening the institution's books and records to both plaintiffs' and defendants' lawyers exact a heavy toll. In addition, private institutions are reluctant to reveal their proprietary investment strategies in the course of litigation. Public institutions, on the other hand, generally do not share this concern because most states have laws requiring the disclosure of this information. Institutions also expressed concern that service as class representative could expose them to liability to other class members. For example, other class members could sue the class representative if the terms of the settlement were claimed to be inadequate. We also have been told that institutions often get a better return by proceeding with their own individual suits. Further, institutions have reported that, if they continue to hold shares, the costs to the company of defending the suit may outweigh any damages that the institution is likely to receive. The staff will continue to monitor institutional involvement in securities class actions. Safe Harbor for Forward-Looking Statements <(15)>(...continued) Partners, L.P.); Sweetwater Inv., Inc. v. Pepsi-Cola Puerto Rico Bottling Co., No. 96-8671-CIV-ZLOCH (S.D. Fla., N.Div., complaint filed Oct. 15, 1995) (Sweetwater Investments, Inc.); Chan v. OrthoLogic Corp., No. CIV 96-1514 PHX RCB (D. Ariz., complaint filed June 24, 1996) (City of Philadelphia). ======END OF PAGE 14====== Our Staff Report also found that companies are not taking advantage of the safe harbor to make more forward-looking disclosure. The staff spoke with a variety of issuers who stated that their primary concern is the lack of judicial guidance as to the sufficiency of the required "meaningful cautionary language. They are also waiting to see how other companies are making use of the safe harbor. Concern about potential liability under state law, where the statements may not be protected by the federal safe harbor, was another frequently cited reason for not including more forward- looking disclosure. Definitive appellate rulings on the Reform Act s safe harbor provision will provide more guidance to issuers and will enable us to better evaluate the safe harbor. Discovery Stay The Staff Report also notes that the discovery stay may be avoided by the filing of a parallel state action. Fifty-five percent of the state court cases (35 out of 55) have allegations that are essentially identical to those brought by the same law firm in federal court. It is reasonable to assume that these cases were filed primarily to get discovery for use in the federal action. ***** IV. ANALYSIS OF STATE COURT COMPLAINTS As part of our ongoing efforts to monitor the progress of the Act and its impact on investor protection, the Commission's staff has been studying securities class actions brought in state courts. Concerns have been raised that the Act has led to a migration of cases to state courts where federal reforms likely do not apply. Unlike federal class actions, notice ======END OF PAGE 15====== does not have to be given to shareholders when actions are filed in state court. As a result, tracking state court cases is more difficult and the numbers are less reliable than those available for federal filings. Nonetheless, Stanford University s Securities Class Action Clearinghouse has identified approximately 90 securities class actions that have been brought in state courts since passage of the Reform Act, approximately 50 of which have been brought in California.<(16)> The staff has obtained and reviewed a total of 55 state securities class action complaints. While this sample may not be representative, the staff s review of those complaints discloses the following: * The state court suits have primarily been brought in California -- 78% of the cases (43 out of 55) have been brought in this state; and * Companies are being sued in states where they are either incorporated or have their principal place of business. Very few -- 7% (4 out of 55) -- have been sued in states where they do not have such ties The NERA study released two weeks ago concludes that the number of state securities fraud class actions filed thus far in 1997 is significantly lower than in 1996. In fact, NERA finds that the number of 1997 state cases, like the number of federal suits, is roughly equivalent to the average number filed in the five years prior to the Reform Act. Raw numbers aside, we have uncovered other interesting data about state lawsuits. The Staff Report analyzed a small sample of 1996 state <(16)> Securities Class Action Clearinghouse -- State Complaints (last modified July 14, 1997) (located at http://securities.stanford.edu). ======END OF PAGE 16====== court complaints.<(17)> In the chart below, we compare the allegations in federal complaints with the allegations found in all of the state complaints in our sample, and with the state complaints that have no parallel federal action: Allegations Federal Stand-Alone Stand-Alone Complaints plus Parallel State State Complaints Complaints Failed 12% 15% 25% Forecasts Insider 48% 46% 25% Trading Accounting 43% 38% 31% Irregularities Financial 18% 15% 13% Restatement Government 15% 8% 6% Investigation Ponzi Scheme 2% 0% 0% The small sample size (26) does not allow for a definitive assessment of the state complaints. The staff analyzed these complaints merely to categorize the nature of the allegations, and could not attempt to judge the merits of the lawsuits. But the chart is nevertheless instructive. While the allegations in the state court complaints overall are substantially the same as allegations in federal complaints, the stand- <(17)> The sample consisted of 26 complaints. ======END OF PAGE 17====== alone state complaints contain a somewhat different mix of allegations. For example, the percentage of state failed forecast cases is double the federal percentage, and the percentage of state insider trading cases is approximately half that of the federal complaints. The parallel state court complaints, not surprisingly, contain allegations nearly identical to their federal court counterparts. The stand-alone complaints in the sixteen cases reviewed by the staff, which are not subject to the federal pleading standards, are less likely to contain allegations of fraud other than a failed forecast. What caused the increase in state court filings in 1996? Some believe that the main reason is the availability of discovery. As noted, many of the state cases were filed parallel to a federal case, presumably for the purpose of seeking discovery that would not otherwise be available in the federal action due to the discovery stay. Some suggest that the increase in 1996 state court filings may have resulted from efforts to avoid the federal safe harbor for forward-looking statements. Fifty-three percent (29 out of 55) of the state cases the staff charted include claims based on forward-looking statements, as well as other claims; while 11% (6 out of 55) of the cases are primarily based on forward-looking statements. Another factor which makes state court lawsuits increasingly attractive is the Supreme Court's decision in Matsushita Electric Industry Co. v. Epstein.<(18)> This decision, handed down a few months after passage of the Reform Act, held that a state court judgment dismissing a state class action pursuant to a settlement agreement could include a <(18)> 116 S.Ct. 873 (1996). ======END OF PAGE 18====== provision barring federal securities fraud actions arising out of the same transaction. By allowing defendants to obtain a global settlement in state court, Matsushita made state court class actions more advantageous for plaintiffs. Accordingly, it is possible that there would have been an increase in state court class actions even if the Reform Act had not been enacted.<(19)> California has been the most popular forum for these state court filings. At least two factors contribute to California's popularity. The first is the absence of a requirement -- which most states have -- that an individual plaintiff prove that he relied on a misstatement or an omission. Proving individual reliance makes a class action unwieldy because individual questions of fact would predominate over the questions common to the class. In Mirkin v. Wasserman,<(20)> the California Supreme Court stated that plaintiffs need not plead or prove actual reliance in an action under the state's securities law. California s elimination of the reliance requirement makes possible a state class action for securities fraud. The other factor is the availability of jurisdiction over high- technology firms, who are frequently named as defendants in securities <(19)> State courts may offer advantages to plaintiffs other than discovery and relief from the safe harbor. These include, depending on the state, easier pleading standards, non-unanimous jury verdicts, punitive damages, joint and several liability, and aiding-and-abetting liability for secondary actors. <(20)> 858 P.2d 568, 580 (Cal. 1993). At least three other states do not require reliance for blue sky fraud actions, see Rosenthal v. Dean Witter Reynolds, Inc., 908 P.2d 1095, 1106 (Colo. 1996); State v. Superior Court of Maricopa Cty., 599 P.2d 777 (Ariz. 1979); Weatherly v. Deloitte & Touche, 905 S.W.2d 642, 648-49 (Tex. Ct. App. 1995), while one state trial court has adopted the fraud-on-the-market doctrine under that state's blue sky law, see Bierman v. Thompson, No. DV-96-124A (Mont. 11th Jud. Ct., Flathead Cty., Oct. 15, 1996). ======END OF PAGE 19====== suits. Silicon Valley contains the largest concentration of high- technology firms in the United States. Those firms tend to have a volatile share price. In addition, those firms often compensate their officers and directors in company stock and stock options, which means that these individuals will be more likely to sell shares during a period of volatility. Insider sales and volatility are frequently relied upon by plaintiffs when pleading fraud. Thus, California state courts provide an attractive alternative to federal courts for securities class actions. ***** ======END OF PAGE 20====== V. POTENTIAL STATE DEVELOPMENTS It remains to be seen whether California state court actions will remain a viable long-term alternative to filing in federal court. The California legislature may take steps which will affect the future of state court class actions. California State Senator John Vasconcellos recently introduced a bill that would incorporate the provisions of the Reform Act into California state law.<(21)> If enacted, this bill would substantially diminish California s attractiveness as an alternative forum. Already three other states -- Arizona, Montana, and Ohio -- have enacted their own versions of the Reform Act, and other states may well follow suit.<(22)> Judicial developments also may affect the ability of plaintiffs to bring state class actions. Most significantly, the California Supreme Court has a case pending before it, Pass v. Diamond Multimedia,<(23)> which calls upon the court to decide the currently unsettled question of whether the state's securities laws apply to transactions taking place outside of California. If the court rules in favor of the defendant issuer, then nationwide class actions will be unavailable in California. Plaintiffs' lawyers would be unlikely to look to state court if they could not bring a nationwide class action. In addition to the statutory question to be decided in Diamond Multimedia, there are constitutional limits that can prevent a state court <(21)> SB No. 35 (introduced Dec. 2, 1996). <(22)> Ariz. Rev. Stat.  44-2081-2087; 1997 Mt. Laws 468; Ohio Rev. Code Ann.  1707.432-438. <(23)> Case No. CV-758927 (Santa Clara Cty. Sup. Ct.). ======END OF PAGE 21====== from certifying a nationwide class. The United States Supreme Court has held that the claims asserted by each member of the plaintiff class must have a significant contact with the forum state in order for that state to apply its law.<(24)> The California Supreme Court, and other state courts, will eventually have to decide whether this test is satisfied in a securities class action. Finally, state courts voluntarily may import the provisions of the federal Reform Act. For example, some state courts, guided by the Reform Act, have imposed a stay of discovery while a motion to dismiss is pending.<(25)> State courts also may look to and incorporate other provisions of the Reform Act, such as the safe harbor. ***** VI. PREEMPTION OF STATE ACTIONS Various proposals have been put forward that would broadly preempt private state antifraud actions. While we are extremely sensitive to the concerns raised by the high-technology community and others that frivolous litigation continues to burden capital formation, we counsel caution in responding to these concerns in order to avoid impairing the rights of investors with meritorious claims. To this end, any proposals that restrict investors rights to recover for injuries they have suffered should be narrowly tailored to address documented abuses. <(24)> Phillips Petroleum Co. v. Shutts, 472 U.S. 797, 821-22 (1985). <(25)> Milano v. Auhll, No. SB 213 476 (Oct. 2, 1996); 1 SEC. REF. ACT LITIG. REP. 870 (Aug. & Sept. 1996); Sperber v. Bixby, Case No. 699812 (Cal. Super. Ct., San Diego Cty., Oct. 18, 1996). ======END OF PAGE 22====== The Commission believes that the states should be afforded an opportunity, in the first instance, to address and resolve issues arising under their own securities laws that may affect the Reform Act s effectiveness. If these issues are not resolved appropriately and if frivolous lawsuits migrate to state court and undermine the Reform Act s provisions, additional federal legislation may well be in order. On the present record, however, we believe that broad preemption is not needed to facilitate the goals of the Reform Act. Broad preemption could have the unintended effect of preempting certain types of cases arising from transactions in which both the states and the federal government have a strong interest. For example, the proposals we have seen could preempt state actions based on material misstatements in proxy and tender offer materials in connection with an extraordinary transaction which may give rise to claims under both state corporate law and federal securities law. Shareholders who bring suit challenging such transactions in these cases typically allege a breach by target-company directors of their fiduciary duties under state corporate law, including the duty of disclosure. Such actions now may be brought in either or both state and federal court. If state-law actions were preempted, plaintiffs would be forced to either bring two suits or bring all their claims in federal court where most judges do not have the familiarity and expertise in corporate law issues that state courts, such as those in Delaware, have developed. ***** The Reform Act became law only a year-and-a-half ago. There has not been enough time to gain sufficient practical experience with the Reform ======END OF PAGE 23====== Act's key provisions or to develop an authoritative body of court decisions interpreting the Act. It will take additional time for the effects of the Reform Act to become clear -- most importantly, whether it deters frivolous actions while allowing meritorious ones to proceed -- and to judge whether the plaintiffs' bar is abusing the remedies available in state court. Those state court remedies traditionally have been an important component of investor protection. Preemption of those remedies based on limited data or before the states have had a chance to respond to the changes in litigation practice brought about by the Reform Act would be premature. As always, the Commission and its staff will be pleased to assist the Subcommittee as it goes forward. ### ======END OF PAGE 24====== STATEMENT OF ADDITIONAL VIEWS OF COMMISSIONER WALLMAN REGARDING THE TESTIMONY OF THE SECURITIES AND EXCHANGE COMMISSION BEFORE THE SUBCOMMITTEE ON SECURITIES COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE July 24, 1997 The Commission has submitted testimony before the Subcommittee concerning the impact of the Private Securities Litigation Reform Act of 1995 (the Reform Act ). In this testimony, the Commission concludes that preemption of certain state class action securities litigation would be premature due to a lack of a definitive assessment of the impact of the Reform Act. I write separately because I believe that the Commission has neither examined nor addressed the broader policy issues raised by the issue of preemption in a manner that would allow it to draw any conclusion on the issue. I, of course, agree with the portion of the testimony that concludes it is too soon to make a definitive assessment of exactly how the Reform Act will be interpreted and what its ultimate impact will be. It will take some years before definitive interpretations of some of its provisions are issued by appellate courts -- and years before industry and others react fully to the changes. But I do not believe it is appropriate to conclude ======END OF PAGE 25====== that, because there is much unsettled in the Reform Act, no action can be taken to address other matters such as preemption. The issue of preemption is broader than the potential effectiveness of the Reform Act, even though the Reform Act s effectiveness may be the current catalyst for raising the matter and an important part of the current debate. Disparate, and shifting, state litigation procedures may expose issuers to the potential for significant liability that cannot easily be evaluated in advance, or assessed when a statement is made. At a time when we are increasingly experiencing and encouraging national and international securities offerings and listings, and expending great effort to rationalize and streamline our securities markets, this fragmentation of investor remedies potentially imposes costs that outweigh the benefits. Rather than permit or foster fragmentation of our national system of securities litigation, we should give due consideration to the benefits flowing to investors from a uniform national approach. That analysis can be pursued, and conclusions reached, regardless of whether one believes we now know -- or will, within any reasonable time, know -- the definitive impact of the Reform Act. Moreover, the Commission seems to take the position that the burdens and costs imposed by disparate state laws may dwindle over time. The Commission seems to argue that uniform national standards may well be reached through a combination of changes to codes of civil procedure and state statutes, coupled with judicial interpretations, constitutional limitations and the determinations of plaintiffs lawyers as to the value ======END OF PAGE 26====== of class actions that might involve solely the residents of a state such as, for example, California as opposed to a nationwide class. Consequently, the argument goes, preemption is premature until this alternative of preemption by the states themselves, or judicial preemption, is found wanting. I cannot agree that this strategy advances any interests of investors. I understand that some believe the Reform Act went too far, while others believe it did not go far enough. But for those who believe the Reform Act is flawed, a better answer might be to work to improve it at the federal level, rather than accept fragmentation of our national system of securities litigation. Consequently, I cannot support the view that determining the merits of preemption must await either an analysis of the definitive impact of the Reform Act, or the resolution of whether the states eventually will, through various means pieced together, preempt themselves. Instead, I believe an appropriate process designed to address the underlying policy issues of preemption, whether through Congressional hearings or otherwise, would be useful, and would allow a conclusion to be reached on whether preemption is, or is not, appropriate. ======END OF PAGE 27======